Stocks generally move inversely to the 10-year yield, making it a key indicator for future market movements. When the 10-year yield is over 2%, it’s time to rethink a stock portfolio. Risk-free yields are at a 52 week high of 2.22%, so it’s time to start moving out of defensive dividend and income stocks.
Why treasury yields matter
The 10-year U.S. Treasury is the most important metric on Wall Street. Institutional investors use the Treasury yield to forecast inflation expectations, price corporate debt issues, and value future corporate earnings.
Remember, when you and I want to move to cash, we can move funds to our bank account. When hedge funds, banks, and institutional investors move to cash, they move to U.S. Treasuries.
The U.S. Treasury yield is especially important for yield-driven investments because it is a safe alternative to risk assets. When investors want yield but limited market risk, they turn to the government’s debt. Government debt is “risk-free” in the sense that the government can always print more money.
Stocks most affected by risk-free yields
Treasury yields deliver the largest impact on “safer,” above-average dividend paying companies. This list includes real estate investment trusts (REITS) and utilities.
When the 10-year Treasury hits 2%, investor cash begins to flow from stocks, especially dividend-paying equities. That sparks a decline in stock prices.
So what’s up with government bonds? The 10-year risk-free rate struck a low of 1.61% on May 1, 2013. Yields rose rapidly to 2% by May 21. Today, yields rest at 2.22%.
10 Year Treasury Rate data by YCharts
On May 22, REITs took a tumble. Realty Income Corp (NYSE:O), which brands itself as “The Monthly Dividend Company,” fell from $55 per share to a low of $43 per share as risk-free yields surged higher.
Realty Income Corp (NYSE:O)’s monthly dividend policy plays into the “clientele effect,” attracting investors who care about income from their investments. Rising risk-free rates can lure income investors away from REITs.
Higher rates also undermine its business model, which relies on inexpensive financing for its portfolio of leased property. Rising rates are a double whammy for REIT investors. Falling rates, however, can drive REITs higher and higher.
Realty Income Corp (NYSE:O) currently yields 4.3%, which is only a modest premium to the 10-year risk-free rate of 2.17%, given the riskiness of commercial real estate and the volatility in the stock market.
Another slammed sector
Utilities show even stronger correlation to Treasury yields, because regulated utilities are financing companies in disguise. Utilities have only minor economic exposure; electricity and gas demand is fairly stable in booms and busts. Thus, the most important metric is the spread between financing costs for major investments and earnings from the sale of utility services.
The Utilities SPDR linked an impressive succession of up days in 2013 to rally all the way to May 1, when US Treasury yields sunk to a 2013 low of 1.61%. As rates rose through May and June, utilities as a whole declined by nearly 8%.
Once again, the spreads between riskier utility dividends and U.S. Treasury Note yields compressed. Utility stocks fell in response. Utilities yield 3.8% vs. 2.17% for the 10-year Treasury. Given recent market volatility, 2.17% in risk-free assets isn’t such a poor alternative to modestly higher utility dividend yields.
Stock investors cannot ignore bonds
Investors should not ignore the hidden risk in so-called “safe haven” stocks. The only truly safe asset is U.S. Treasury debt, so the yield on this very important asset sends shockwaves through the rest of the market.
When the market is rising month after month, it’s easy to forget that stocks are the riskiest of asset classes – even “safe” REITs and utility companies. However, sentiment can reverse quickly when tempted with higher bond returns.
The article Why Does the Market Love U.S. Treasuries? originally appeared on Fool.com and is written by Jordan Wathen.
Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Jordan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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